3

5 Questions for Netflix and Microsoft

How surprised were you to see Netflix (Nasdaq: NFLX) team up with Microsoft (Nasdaq: MSFT) to offer its Watch Now streaming video service through the Xbox 360?

Not very? Join the club. I've been expecting this since Netflix CEO Reed Hastings landed on Microsoft's board of directors 16 months ago. Then again, I also predicted that the board appointment would lead to Netflix renting Xbox games, and that Hastings would help MSN improve its sluggish dot-com ways. (Nobody's perfect.)

Netflix's Watch Now service currently allows existing subscribers to stream roughly 10% of the 100,000 DVD titles available, at no additional cost. Microsoft announced Xbox 360 compatibility during this week's E3 industry trade show, but it won't come into play until late fall.

Like many corporate moves, an answer attracts yet even more questions. Now that the news is official, I'm left with five new questions:

1. Will the Xbox replace the PS3 as the home theater appliance of choice?By deciding to sell an HD-DVD peripheral for the Xbox 360, Mr. Softy banked on the loser in the optical-disc battle to replace the DVD. Blu-ray, championed by Sony (NYSE: SNE) , is standard in every PS3, won the war. This has given the PS3 a marketing edge, since families can buy the console as a game machine, yet also spare themselves the expense of a higher-end stand-alone player.

Adding Netflix to Xbox 360's arsenal helps rebalance the marketplace. We may not know the exact overlap between Netflix members and Xbox Live Gold subscribers (Xbox owners must be paying Live subscribers to use the Netflix service), but it's probably safe to assume that the kind of consumer that shells out for both subscriptions is probably a very juicy demographic.

Potential buyers weighing the PS3 vs. 360 decision now have to consider whether they want the superior imagery of Blu-ray (and its premium price) or the cheaper allure of on-demand flicks at no extra cost. In this dicey economy, you have to like Microsoft's chances. Sony is just starting to ramp up its digital video store, but Microsoft is already undercutting its peer.

2. Will this help or hurt Microsoft's move to sell video downloads and rentals?There's a downside to every selling point. For Microsoft, streaming unlimited flicks from Netflix at no additional charge -- no matter how limited the current selection -- might also dent the company's nascent digital video offerings. Why buy when you can settle for something else for free?

Thankfully for Microsoft, history has done a good job of testing this out. Cable operators like Comcast (Nasdaq: CMCSA) have been offering free on-demand films to digital cable subscribers for years, alongside premium pay-per-view fare. Does offering free content make Comcast stickier? Are the freebies essentially gateway drugs to lure new users into upgrading to the premium new release? I'm betting Comcast wouldn't offer the free stuff alongside its a la carte menu if it didn't make good financial sense.

3. Who is the other heavy hitter backing Netflix?"We have LG plus three additional partners actively working on integrating our technology into their products," Hastings said during last month's quarterly conference call. Two of the three "sell millions of devices per year" he added, projecting that full Watch Now functionality would come online during this year's final quarter.

We now know that the small player is Roku, whose Netflix Player debuted in May. Microsoft is obviously one of the two heavyweights. Can the final horseman be anyone other than TiVo (Nasdaq: TIVO) ? The digital-video-recorder pioneer has been upgrading the functionality of its networked boxes lately. Whether by streaming tunes from RealNetworks' (Nasdaq: RNWK) Rhapsody or YouTube video clips, TiVo continues to justify its market premium.

4. Will Netflix begin renting Xbox 360 games?Netflix loves to dismiss this question. Renting games isn't an easy business. The titles cost too much, damage too easily, and age too quickly. However, just as Netflix is willing to take a financial hit from online streaming to grow its base and nurture loyalty, isn't it a matter of time before Microsoft hooks up with Netflix to offer 360 title rentals?

Even as both companies barrel toward a digitally delivered future that will make physical products obsolete, isn't it in Microsoft's best interest to give Netflix subscribers one more reason to choose a 360 over rival systems? The duo don't have to offer a full slate of titles. Just as Microsoft is teaming up with Take-Two Interactive (Nasdaq: TTWO) to serve up a pair of Xbox-exclusive add-ons to Grand Theft Auto IV, surely Microsoft has the flexibility to slip Netflix a few 360-exlusivie releases.

5. Will Microsoft buy Netflix?I spelled out the reasons why Netflix would be a good catch for Microsoft last summer. The argument is even more compelling today, with Microsoft looking to expand its online presence and turn profitable in that niche at the same time. Netflix would go a long way toward achieving those ends.

Microsoft and Netflix are both in the business of moving discs. They're both grappling with Web-delivered competition, but taking those threats head on. Microsoft authors its content, while Netflix is simply the middleman. However, Microsoft could use a profitable e-tailer with a killer brand, a lucrative subscriber list, and an online niche that won't receive heavy antitrust scrutiny.

Longtime Fool contributor Rick Munarriz has been a Netflix subscriber -- and shareholder -- since 2002. He also owns shares in TiVo. He is also part of theRule Breakersnewsletter research team, seeking out tomorrow's ultimate growth stocks a day early.The Fool has a disclosure policy.

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment icon found on every comment.

Sending report...

Rick has been writing for Motley Fool since 1995 where he's a Consumer and Tech Stocks Specialist. Yes, that's a long time. He's been an analyst for Motley Fool Rule Breakers and a portfolio lead analyst for Motley Fool Supernova since each newsletter service's inception. He earned his BBA and MBA from the University of Miami, and he now lives a block from his alma mater.
Follow @market